The Apprentice Economist

by Filip Palda

  the apprentice economist

  seven steps to mastery

  Filip Palda

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  COPYRIGHT ©2013 BY FILIP PALDA. All rights reserved. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief passages quoted in critical articles and reviews. Students may extract longer segments for school essays.

  Published by Cooper-Wolfling. None of the advisory board of Cooper-Wolfling are responsible for the opinions expressed in this text, which remain the responsibility of the author.

  Editor: J. Kristin McCahon

  Typesetting and final design supervisor: Le Chevalier Grimaud De Rompidrac

  Proofreader: Mirja van Herk

  Cover design and typesetting: Stare Zamecke Schody Studios. Set in Minion Pro.

  About the cover: The cover represents the “Ascent to Knowledge” and is the particular idealization by trans-conceptual artist Hanka Fecit. The cover model was provided by Goldpidgeon Productions.

  Palda, Filip, 1962–

  The Apprentice Economist / Filip Palda.

  Includes bibliographical references.

  ISBN 978-0-9877880-4-7

  THIS BOOK IS CERTIFIED TO BE SUBSIDY FREE. NOT ONE DOLLAR

  OF TAXPAYER MONEY IN THE FORM OF SUBSIDIES OR DEDUCTIONS

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  WWW.APPRENTECON.COM

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  About the author

  FILIP PALDA EARNED his Ph.D. in economics at the University of Chicago.

  * * *

  Dedication

  TO MY MOTHER, THE ORIGINATOR AND THE ORIGINAL

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  Contents

  About the author

  Dedication

  1 PREFACE

  2 SUBSTITUTION

  3 TIME

  4 CHANCE

  5 SPACE

  6 EQUILIBRIUM

  7 GAMES

  8 CONTROL

  9 EPILOGUE

  PREFACE 1

  MASTERING ANY DOMAIN OF KNOWLEDGE is hard. Some psychologists estimate it takes about three thousand hours of concentrated study simply to start being able to contribute in a meaningful way to your chosen field. Assuming you could devote a maximum of eight hours a day to perfecting yourself, then under these conditions you would have to study almost three years, and more likely five or even seven. Seven years is the time it traditionally took to pass from being an apprentice to a journeyman in trades such as instrument making, goldsmithing, surgery and barbering. The Beatles may just have spent this amount of time performing, and honing their skills before their success.

  Becoming a master of economics is not easy, mainly because it is a new science. Pedagogy has been a straggler in the march to understanding. First year economics classes dumb down the subject, and try to make it “accessible” to the many. This has the result of making it accessible to few. That should be no surprise. Have you ever heard of an easy course in bodybuilding? How about Endurance Running 101 in which you attain the toughness of a marathoner without ever breaking a sweat? The mind is like a muscle. It needs to be stressed before it can grow.

  The established sciences are well aware of this. Physics courses the world over pose a challenge. So should economics. There is no short-cut to core concepts, whatever the discipline. The current explosion of wannabe economic best-sellers in popular bookstores turn their faces from this awkward fact. They seek to make economics accessible from the armchair, a topic for midnight reading, sexy, and even freakish. They appeal to the reader’s vanity rather than to his or her appetite for knowledge for its own sake.

  To be fair, you will also find on a nearby bookshelf popular physics books which try to make that science accessible. But you will also find they are serious works that make little compromise with the reader’s demand for instant understanding. Physics books don’t expect you to grasp all the intricacies of that science. They seek to help you understand what are the great questions in physics and how physicists go about answering them. How many popular books in economics give you that? By cravenly reducing their expositions to jokes and meretricious anecdotes, economists who try to explain their topic to the wider world are working on the assumption that the topic can only be washed down with beer and popcorn. Such an approach is unfair to the curious.

  To the curious, economics may seem a fragmented science. No such confusion existed in the minds of those who founded the field. Economics was a 19th century reaction to rapid social change that made people question the value of the societies in which they lived. Was economic growth worth the upheaval to customs and mores? Did government have a role in moderating the rapid changes taking place? The answers depended on how you weighed the outcomes the modern economic system produced. Put more figuratively, economics came into being as a means of calculating whether social accounts were in balance. Did the capitalist system give workers sufficient reward for their efforts? Did communism promise a better reward system for organizing society? Such questions had seldom been asked with any force because there had been no call for the answers. For most of history people lived in static economic and social settings. Little changed. The absence of change allowed people to gradually figure out means of balancing social accounts without the aid of worldly philosophers. The need for economics arose when the world started to change too rapidly for governments to really understand where things were going. Those in power turned to economists because they were the only ones who had developed a rough but logically coherent means of thinking about how social accounts added up under different government policies.

  A clear and quantifiable idea of the basis of social cohesion is why economics remains the only guide which the mass, anonymous societies of today can use to avoid blundering into depression and even chaos. Economists who think their topic is a tap-dance should seek a calling in the entertainment industry. Economics is a noble undertaking in which there is no place for the intellectual kibitzer, the gag-artist, the purveyor of trivia. If such solemnity strikes you as being excessive, think of “Boozy Barley” Blair in John LeCarré’s The Russia House explaining in his cups that “today you have to think like a hero to be a merely decent human being.”

  But does a heroic science call for heroic sacrifice on the part of those who would understand it, at least in its outlines? Just as in physics, there are no shortcuts to mastery in economics. But there are ways to avoid needless confusion. Some people breeze through the study of difficult topics to become masters in a short time. These are the ones we see relaxing at the bistro chatting and laughing with friends while the rest of us toil at our desks in fear of the next examination. Are they so much better than the rest of us? Yes they are. But not because of some otherworldly talent. They are better because they have a knack for getting to the heart of the matter. They know which steps lead to the heights of knowledge. They expend effort, though not needless effort.

  What are these steps that can help one to master economics elegantly instead being crushed grossly by the challenge? I believe them to be seven. The first four are basic units: substitution, time, chance, and space. Each has fundamental insights that are applied in all other fields of economics. The way to snap the basic pieces together is through equilibrium analysis, which is the fifth step. Game theory is the sixth step because it draws on the first five steps but itself also makes fundamental contributions from which the first five steps can benefit. Standing seventh, at the top, is the idea of statistical control. Only once we have understood theory of economics, can we then proceed to test these notions. That is what statistical control is about.

  Such a list may seem simplistic to some and may even smack of dilettantism to others. What about Ricardo’s principle
of comparative advantage? Or Say’s law? How about the median voter theorem? Deadweight loss? The impression of a café terrace approach to economics mounts as one consults the Journal of Economic Literature classifications of economic fields. There are twenty major fields, close to a hundred subfields, and over five hundred fields within the subfields. I won’t even attempt to quantify the number of economic journals. Their number blooms like plankton and their nutritional value is about as hearty. How can such a massive archive be reduced to a few hundred pages?

  None of that should bother us. Let us take our cue from Nobel Prize winner Robert E. Lucas Jr. When asked how he kept up with all the literature being published in economics he answered that it wasn’t really that difficult as there were no more than a handful of articles worth reading. It is a handful upon which I have based the seven steps to economic mastery. Reading original sources is a refreshing surprise. For example, Harold Hotelling’s 1929 article “Stability in Competition” is clearer reading than almost anything on the topic that has followed. Sherwin Rosen’s “The Theory of Equalizing Differences” is one of the masterpieces of economics and it has kept many an economist busy since it was written in 1986. Even von Neuman and Morgenstern’s Theory of Games and Economic Behavior, though considered the most quoted but least read work in economics, does in fact have a few passages which are comprehensible to people just marginally below the genius level. Breadth reading is not needed to master economics. Depth reading is the key.

  And that is where the book you are holding comes in. You do not need to go back to these original sources to get the basic message of economics. I have distilled these sources for you. You will find the results in the pages that follow. The only thing you need to appreciate is my method. I am not providing a survey of all ideas in economics. Some readers will be shocked to discover that I make no mention of a great many economic giants. My purpose is not to trace intellectual pedigrees. My purpose is to give you what it takes to not only understand what economics is about but to allow you to develop the instincts of the masters who developed this field and whose knowledge is within anyone’s grasp.

  In my quest to render advanced economic concepts comprehensible to all I have been aided by my conceptual editor Kristin McCahon. Kristin is a prominent editor with over thirty years of experience in being what she describes as an “advocate for the reader”. Over the years it has taken to write this book Kristin has been present and has exercised her talents to make the writing clear to all. I owe her an immense debt of gratitude. I am as usual indebted to my father Kristian Palda for his help. As a teenager he left the remnants of his family, devastated by Nazi depredations, and friends behind and fled Stalin’s agents as they encroached upon his beloved Czechoslovakia and issued warrants for his arrest as an enemy of the socialist state. His crime being that he was the son of a capitalist. Under communism, as under Nazism, genetic circumstances were deemed grounds for prosecution. Nazis prosecuted Jews and other minorities. Communists had an aversion to the bourgeois chromosome. I make much of it but others suffered worse and I never heard my father complain or speak ill of his tormentors. He made his way from Bremerhaven on a United Nations ship to Halifax as a “DP” or “displaced person”, drifting, after a decade of menial work to Chicago where he earned his Ph.D. at the University of Chicago under Nobellist George Stigler. That training honed his already superlative intellect to a fine edge. He has used it, and the unique perspective on life his experiences have given him, to help me cut away a great deal of superfluous and needlessly complicated material. Above all he has reminded me that economics is not only a science, but is also one of the humanities. As a humanity it is a tool which should enhance one’s culture and thus aid individuals to improve themselves and the society in which they live.

  I thank Mirja Von Herk who has provided proofreading. All remaining faults and mistakes remain mine alone. I also wish to thank the management and staff of Cooper-Wolfling Publishers for their confidence in this project and their support over the years it has taken to realize it, and the generous use of their facilities and research staff. I thank professor Bernard Kavanaugh of the Latin department of Queen’s University for showing me how to translate “out of games, honesty and obedience” into “ex ludis probitas et oboedientia”. I thank Sébastien Coté for his ideas on bringing this book to a wide public. I especially thank my university the ENAP (National School of Public Administration), and its academic director André Bourret, for providing the intellectual environment necessary for the gestation of this project. ENAP is a multidisciplinary school which takes a long-term view of research and gives its scholars the latitude to create.

  I also thank Jaffer Qamar, a Ph.D. graduate from the economics faculty of the University of Chicago with whom I have been carrying on a running economic conversation ever since we met there close on thirty years ago now. He encouraged me, after the positive reception of my earlier book Pareto’s Republic, to go deep and fill a gap he felt existed in economics. Namely the lack of a survey of the key concepts which was not dumbed down but which at the same time was suited to the curious. That he said was the challenge. Only you may judge whether it has been met.

  References

  Hotelling, Harold. 1929. “Stability in Competition.” The Economic Journal, volume 39: 41-57.

  Rosen, Sherwin. 1986. “The Theory Of Equalizing Differences.” Handbook of Labor Economics, Volume I. Edited by Orley Ashenfelter and Richard Layard. Elsevier Science Publishers. 641-692.

  Von Neumann, John and Oskar Morgenstern. 1953. The Theory of Games and Economic Behavior, Third edition. Princeton University Press.

  SUBSTITUTION 2

  IF YOU ASK PEOPLE TO state the central problem of economics their answer is “to make money!” How to spend that money seldom comes up. Spending is not a problem. It is a pleasure. You spend on things you like and can afford. Economists see things differently. How to make money is not their domain. They leave that to hedge-fund operators and talking heads on the business segment of nightly news reports. How to spend that money is where all economics starts.

  Among the contending definitions of economics, the best known is from Lord Lionel Robbins, who wrote that “Economics is a science that deals with the study of human behavior as a relationship between ends and scarce means which have alternative uses”. You have some “ends” meaning goals, such as making yourself as happy as you can, and you have certain “means”: namely your income and what it can buy. Showing how to satisfy your ends by adjusting your expenditures within your means is the basis of most economics. It underpins supply and demand. It provides the framework for analyzing government policies as diverse as the minimum wage and taxation. It helps us understand how people invest their money in risky situations and how they spread their expenditures over time.

  It took economists from 1838 and the publication of Augustin Cournot’s Mathematical Treatise on Wealth until 1915 and Eugen Slutsky’s definitive mathematical theory of consumer behavior to understand the issues involved in how people substitute one item of interest for another based on their relative prices. Finding the solution was not the hard part. Stating the problem correctly was where the problem lay. The notion of “trade-offs” is where all ruminations began. So let us see what that means from an economic perspective.

  The pervasiveness of trade-offs

  ECONOMISTS STUDY THE choices people make from a scarce, or limited range of options. Without scarcity, we would have little to study. Infinite abundance means having everything and so never having to make hard choices. If instead, your resources are limited, you can only use more of something by using less of other things. This may sound obvious but the idea is generally absent from debates on public policy. Almost daily we hear calls for government to spend more to “stimulate” the economy, but how often do we hear it said that the money to stimulate must be pulled from some other part of the economy that will then be de-stimulated?

  In our personal lives the concept of a trade-off is cl
ear enough if you go into the supermarket with only cash in your pocket. You know that putting a tin of expensive caviar in your cart means you will have less money left to buy beans. Credit cards obscure this constraint on our choices because they push the reality of payment into a dimly perceived future. Financial advisors and even psychologists do a brisk business of reminding us that trade-offs are not just between the here and now but also between the now and then, which is what economists call “inter-temporal constraints on choice”. If our advisors fail to convince us to change our behavior, then bill collectors will make sure that we very rapidly come to a complete understanding of trade-offs.

  While the need to consume less of something in order to be able to get more of something else is an iron-clad law, there is room for a consumer to seek his or her best purchases within its confines. Economists call this “maximizing utility under a budget constraint”. Here is how it works.

  If a tin of caviar costs twenty-five dollars and a can of beans costs one dollar, then you have to give up twenty-five cans of beans to get an extra tin of caviar. It also means that if you want an extra tenth of a can of caviar you must give up twenty-five tenths of a can of beans. If you want one thousandth of a can of caviar you must give up twenty-five thousandths of a can of beans. More generally whatever extra part of a can of caviar you want, no matter how minute, the minimum similarly fractionated parts of a can of beans you must give up is twenty-five.

  This is what economists are trained to think of when they analyze prices. They are not concerned with the dollar sticker but rather with the relative price of the two commodities. The relative price tells you how that tiniest extra or “marginal” fraction of a good one can be traded off against the other. In more general contexts economists sometimes call this the marginal rate of transformation, but we will just call it relative price. Dollars are important mainly because that is how your budget is measured. If your budget is the fixed sum of a thousand dollars then the relative prices are a guide to how far that thousand can slide you from consumption of one good to the other.